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Decision No. 131-R-2016

DETERMINATION by the Canadian Transportation Agency (Agency) of the 2016-2017 Volume-Related Composite Price Index (VRCPI) required for the Maximum Revenue Entitlement (MRE) program pursuant to Part III, Division VI of the Canada Transportation Act, S.C., 1996, c. 10, as amended (CTA).

Case number:

15-00748

AGENCY DECISION

[1] The Agency is required to determine, by April 30, 2016, the VRCPI for crop year 2016-2017 commencing August 1, 2016 and ending July 31, 2017.

[2] The Agency has determined the VRCPI for 2016-2017 to be 1.3275, an increase of 4.8 percent from 2015-2016.

[3] The VRCPI of 1.3275 will be applied in the legislative formula under section 151 of the CTA when the Agency makes its MRE program determinations for the 2016-2017 crop year by December 31, 2017.

[4] In this Decision, references to 2016-2017 mean the crop year from August 1, 2016 to July 31, 2017.

BACKGROUND

[5] The MRE program, established on August 1, 2000 for the movement of western grain by prescribed railway companies, requires the Agency to annually determine an MRE, commonly referred to as a “revenue cap” for each railway company and to subsequently determine whether each railway company has exceeded its MRE.

[6] Subsection 151(1) of the CTA provides the formula that the Agency is to use in determining the MREs. One of the inputs to the formula is the VRCPI.

[7] Subsection 151(4) of the CTA states that:

The following rules are applicable to the volume-related composite price index:

in the crop year 2000-2001, the index is deemed to be 1.0;

the index applies in respect of all of the prescribed railway companies; and

the Agency shall make adjustments to the index to reflect the costs incurred by the prescribed railway companies for the purpose of obtaining cars as a result of the sale, lease or other disposal or withdrawal from service of government hopper cars and the costs incurred by the prescribed railway companies for the maintenance of cars that have been so obtained.

[8] The development of the 2016-2017 VRCPI involved detailed submissions of historical price information of railway inputs (labour, fuel, material and capital) from the prescribed railway companies, currently the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP). The submitted information was reviewed and verified by Agency staff. In addition, Agency staff developed forecasts for future changes in the price of railway inputs.

PRELIMINARY MATTERS

Adjustment to the 2015-2016 VRCPI

[9] On April 25, 2016, CN filed an application with the Agency, pursuant to paragraph 151(4)(c) of the CTA, for an adjustment to the 2015-2016 VRCPI related to cars obtained from its U.S. subsidiary companies to replace withdrawn federal government-owned hopper cars. The application was supported by a commitment agreement (CA) for the Agency’s consideration. The CA identified over 1,700 cars to be added as replacement cars obtained by CN from its U.S. subsidiary companies for use in regulated grain service. As the 2016-2017 VRCPI is affected by the 2015-2016 VRCPI, the Agency needs to consider CN’s application before it makes its determination on the 2016-2017 VRCPI.

Issue

[10] Is the CA filed by CN acceptable to the Agency and consequently, is an adjustment to the 2015-2016 VRCPI pursuant to paragraph 151(4)(c) warranted?

Analysis and Findings

[11] The conditions to be met for an adjustment under paragraph 151(4)(c) of the CTA were established in Agency 8-R-2013">Decision No. 8-R-2013 and 304-R-2015">Decision No. 304-R-2015. In Agency 374‑R‑2015">Decision No. 374‑R‑2015, the Agency restated these conditions as follows:

Government hopper cars have been sold, leased, disposed of or otherwise withdrawn from service. This is to be demonstrated by third-party evidence indicating the specific car identification number of each car withdrawn and when they were withdrawn, specifically an official letter from the rightful owner of the withdrawn hopper cars.

The railway company has obtained hopper cars as a result of the above.

When the replacement cars are obtained from a U.S. subsidiary, the use of those cars is governed by a CA between the prescribed railway company and its U.S. subsidiary company for the commitment of a specific number of the U.S. subsidiary’s identified owned or leased hopper cars (designated replacement cars) for Canadian regulated grain service for a minimum of one year. The CA must also:

be made in writing;

be entered into by the prescribed railway company and its U.S. subsidiary prior to the actual use of the designated replacement cars in a given crop year;

provide specific car identification numbers of the U.S. subsidiary cars committed for use in Canadian service in replacement of the withdrawn government hopper cars (designated replacement cars);

specify a commitment of the U.S. subsidiary to make the designated replacement cars available for use by the prescribed railway company in Canadian service for a minimum of one year; and,

specify a commitment of the prescribed railway company to use the designated replacement cars in a manner similar to the average historical usage of the government hopper cars in regulated grain service in the year during which the agreement is in effect.

[12] The Agency, for reasons outlined in 304-R-2015">Decision No. 304-R-2015, allowed a paragraph 151(4)(c) adjustment to the 2014-2015 VRCPI for cars obtained by CN from a U.S. subsidiary company, but stated that an adjustment to the 2015-2016 VRCPI would not be allowed until a satisfactory CA was filed by CN.

[13] The Agency has examined the CA filed by CN and finds that it meets all of the established requirements for an acceptable CA as noted above. The Agency is now satisfied that all of the conditions for an adjustment to the 2015-2016 VRCPI have been met by CN.

Conclusion

[14] The Agency adjusts the 2015-2016 VRCPI upwards to 1.2668 (0.8 percent from its value of 1.2571 set out in114-R-2016"> Decision No. 114-R-2016 dated April 13, 2016) and makes this adjustment effective August 1, 2015, pursuant to subsection 151(6) of the CTA. The Agency has calculated this adjustment in accordance with the methodology established in 304-R-2015">Decision No. 304-R-2015.

METHODOLOGICAL ISSUES

[15] In accordance with the established process for managing proposals for methodological or interpretive changes related to the VRCPI, Agency staff, by letter dated January 14, 2015, reminded CN and CP that the deadline for submitting any such proposals was August 15, 2015. No new proposals for methodological or interpretive changes were submitted by industry participants for consideration by the Agency for the 2016-2017 VRCPI.

[16] However, as part of its determination of the 2016-2017 VRCPI, the Agency has identified two potentially material issues that may require methodological change, specifically with respect to:

the calculation of the material price index; and,

the establishment of CP’s capital structure, an element used to calculate its cost of capital.

Material Price Index Issue

[17] Each year Agency staff verify historical price indices submitted by CN and CP for the various components of the VRCPI, including labour, fuel, material and investments.

[18] Over the course of a year, a railway company purchases over 10,000 different items for use in carrying out, maintaining and otherwise supporting its operations. Given the complexity involved in tracking the changes in price of each of these items, a select sample of approximately 180 significant items are chosen each year to construct the railway company’s material price index.

[19] There are two sources of information used to derive the material price index, one for the prices and a second for the weights attached to those prices. The first source is the purchase order database (PODB), which reflects the details of all material purchases made by the railway companies. From this information, a price index is calculated for various expense components, including for locomotives, freight cars, signals, and track and roadway. Each of the price indices is then weighted and combined into a composite price index. The weights are derived from the railway company’s financial statements.

[20] During this year’s exercise, Agency staff discovered that the PODB did not include fuel expenses, other than locomotive diesel fuel (other fuel), which account for a significant portion of the material expenses reflected in the railway companies’ financial statements. Other fuel includes fuel for trucks, heavy machinery, small tools and other vehicles used in railway operations.

[21] The combined effect of CN and CP not including their other fuel expenditures in the material purchase sample with weights that effectively reflect the expenses on other fuels could create a distortionary bias in the material price index, and a new approach would need to be implemented to eliminate this problem.

[22] As such, consistent with the approach for managing proposals for methodological or interpretive changes related to the VRCPI, the Agency is instructing staff, through collaboration with CN and CP, to further investigate this matter with a view to establishing a new approach that eliminates any inherent causes of this distortionary bias. The Agency intends for the new approach to apply to the 2017-2018 VRCPI determination.

CP’s Capital Structure Issue

[23] In accordance with the methodology established in the Cost of Capital Methodology Decision issued by the Railway Transport Commission on July 31, 1985 (1985 Decision), CP was allowed to use a Cash Flow Method for the consideration of CP’s capital structure, which is used in determining CP’s cost of capital. The method allowed CP to apply its cash balance against its long-term debt, thereby reducing its long-term debt and consequently decreasing the proportion of the capital structure assigned to debt financing. This practice, which is inconsistent with generally accepted accounting principles, was, as per the reasons for the 1985 Decision, allowed at the time because CP was the rail division of a larger corporate entity and had no stand-alone balance sheet. The 1985 Decision stated (page 21):

The cash flow approach identified the funds generated by railway operations as well as the uses to which these were put: primarily dividends and new capital programs. By comparing these sources and uses of funds, the annual amount of additional debt incurred or deemed to be retired, could be determined for the rail division.

[24] However, in 2002, the Agency issued Decision No. LET-R-98-2002 (2002 Decision), in which it decided as follows:

The Agency has decided that, in respect of the 2003/2004 crop year, CP will be required to calculate its net rail investment and its corresponding capital structure by following the balance sheet methodology calculation. This approach is appropriate given the reorganization of the parent company, Canadian Pacific Limited. CP is now a separate corporate entity.

Cash Balances

[25] Despite the 2002 Decision, CP has continued the practice of netting cash balances against long-term debt when filing its capital structure, citing the 1985 Decision as its authority to do so. The amounts involved were originally immaterial. However, in the last three years the cash balance amounts have grown significantly and are now considered to be material.

[26] The Agency has allowed CP to apply its cash balance against its long-term debt, despite the 2002 Agency Decision that required it to calculate its net rail investment and its corresponding capital structure by following the balance sheet approach. Consistent with this long standing approach, the Agency determined it appropriate to recognize the cash balance for 2015 in establishing CP’s capital structure used in determining CP’s 2016-2017 cost of capital rate.

[27] However, the Agency considers that CP’s approach raises concerns given that CP’s corporate structure, which once justified the use of this approach, is no longer in place. Considering the materiality of the amounts involved, and in keeping with the process for proposing methodological changes, the Agency will, through staff consultation with industry participants, review its methodology for the establishment of the capital structure for the prescribed railway companies. The Agency intends to rule on an appropriate methodology for application in the 2017-2018 VRCPI determination.

CP Payment

[28] Further, as part of its submission for the 2015 cost of capital determination, CP claims that a material payment made by CP to its parent company, Canadian Pacific Railway Limited (CP Ltd), to cover the parent’s cash shortfall related to a share re-purchase program, should continue to be recognized as cash for CP. CP has applied this payment to reduce its reported long-term debt for 2015.

[29] The Agency has examined the details of the payment made by CP to its parent company CP Ltd. and finds that it would be inappropriate to allow a reduction to long-term debt in this instance as the payment was made during the year and is not a cash balance at year end. The payment is not permissible under the 1985 Decision and will not be applied against CP’s long term debt.

UPDATING OF WEIGHTS

[30] Consistent with past practice, the Agency has updated the weights used in developing this year’s VRCPI. Updating weights regularly is required to ensure that price fluctuations within the various components of the VRCPI are appropriately assigned when the individual price components are combined into the composite figure. In past years, the Agency has relied on cost runs using the latest available unit costs and railway workloads (typically a 1-2 year lag) in determining updated weights. This year, rather than using the cost run approach that reflects weight distributions from 2012, the Agency used 2014 information from the prescribed railway companies’ financial statements to set the weights. As this information is more up-to-date, its use allows the Agency to establish weights that better reflect current railway practices. The use of financial data as opposed to cost runs does not result in significantly different outcomes and allows for weights that are based on the latest information.

DEVELOPMENT OF THE 2016-2017 VRCPI

Major Components of the VRCPI

Labour

[31] The development of the labour price index captures price changes in wages, wage-related items (such as bonuses and stock-based compensation) and fringe benefits (such as government and railway company pensions, and employment insurance).

[32] In developing the forecast for labour for the 2016-2017 crop year, the Agency considered forecasted price changes for each of the major price index components, including wages, wage related items and fringe benefits. Employing the same practice as in previous years, by considering established labour contracts that extend into the future (if available) and relying on projections of historical trends for the remaining sub-components, the labour component of the 2016-2017 VRCPI is forecast to increase by 1.4 percent.

Fuel

[33] The railway fuel price index reflects changes in the average annual price per litre of diesel fuel. The Agency uses a long-established model based on the relationship of railway fuel prices and the price of crude oil (based on the common benchmark West Texas Intermediate). The model also accounts for any known hedging practices, federal fuel excise tax and provincial fuel sales taxes.

[34] The Agency relies heavily on forecasts of international crude oil prices and for the Canada/U.S. exchange rates from a number of expert third-party forecasters as inputs to the Agency’s fuel forecasting model.

[35] The average of the third-party forecasts for the price of crude oil used in the development of the 2016-2017 railway fuel price index is 38.10 USD/bbl for 2016 and 46.30 USD/bbl for 2017. An important element in the development of forecasts for the railway fuel price index is the Canada/U.S. exchange rate as crude oil is purchased in USD. The average of third-party forecasts for the exchange rate is 0.728 USD for 2016 and 0.760 USD for 2017.

Material

[37] Railway companies purchase thousands of different material items each year, far too numerous to track individually. Therefore, the material price index reflects changes in the average annual price of a basket of railway materials, similar to the consumer price index. The Agency’s long established methodology involves a series of regressions based on the major railway material components to forecast (based on third-party data) the average material price change. The model also incorporates forecasts for the Canada/U.S. exchange rate, as an estimated 75 to 80 percent of materials purchased are affected by the exchange rate. For crop year 2016-2017, the Agency forecasts a 1.5 percent increase in the material price index.

Other components

[38] One of the components in this group is the cost of capital rate that is applied to the capital indices. This item has been dealt with separately in Decision No. LET-R-13-2016 and Decision No. LET-R-14-2016. Other components in this group include leased hopper car rates, amortization of investments, and the net impact of replacing 1992 hopper car maintenance costs with more recent actual costs, as determined and implemented in 67-R-2008">Decision No. 67-R-2008 pursuant to Clause 57 of Bill C-11, which passed in June 2007.

[39] This component also includes adjustments made pursuant to paragraph 151(4)(c) of the CTA to reflect the cost changes incurred by CN and CP related to the replacement of withdrawn or leased back government-owned hopper cars. The most recent paragraph 151(4)(c) adjustments affecting the 2015-2016 VRCPI are detailed in the preliminary matters section of this Decision and in 114-R-2016">Decision No. 114-R-2016 issued on April 13, 2016. Both adjustments were related to costs incurred by the prescribed railway companies in obtaining replacement hopper cars from their U.S. subsidiary companies for use in regulated grain service. The two adjustments combined resulted in a 2015-2016 VRCPI of 1.2668, a 1.2 percent increase from the original value of 1.2517 established in 120-R-2015">Decision No. 120-R-2015.

[40] The Agency has applied the appropriate methodologies and cost basis for each of these other components. The combined impact of changes for other components is a price increase of 1.3 percent for 2016-2017. This change is partially attributable to a forecasted decline in the Canada/U.S. exchange rate as compared to 2015-2016, placing anticipated upwards pressure on hopper car leasing prices for the 2016-2017 crop year.

OVERVIEW OF VRCPI CHANGES FOR THE NEXT CROP YEAR

[41] As indicated in the table below, the 2016-2017 VRCPI is 4.8 percent higher than the 2015-2016 VRCPI determined by the Agency in 120-R-2015">Decision No. 120-R-2015 and adjusted by 114-R-2016">Decision No. 114-R-2016 and this Decision. The 4.8 percent increase stems from three main sources:

a 2.2 percent increase attributable to the effect of replacing last year’s forecasts of price changes for railway inputs for 2015 with actual (preliminary) data and incorporating revised forecasts for 2016 (from this year’s exercise);

a further 1.2 percent increase attributable to updating the index weights based on the prescribed railway companies’ 2014 financial statements; and,

a 1.4 percent increase in forecasted price changes for railway inputs for the 2016-2017 crop year.

[42] The 2.2 percent increase described in i. above is in part attributable to the sharp decline in the Canada/U.S. exchange rate between 2014 and 2015 and the fact that the dollar is forecast to decline even further in 2016. The weaker Canadian dollar increases the cost to purchase materials used in the day to day operations of the railway companies, as many of these items are purchased in USD. Last year, the Agency’s material price forecasting model underestimated the price change for railway materials in part because third‑party forecasts used for the Canada/U.S. exchange rate for 2015 and 2016 were too high. Another element contributing to the 2.2 percent increase, but to a lesser degree, is that the weaker dollar increases leased car costs as lease rates are often negotiated in USD.

[43] Updating the weights of the various component indices of the VRCPI has led to an increase in the index of 1.2 percent as indicated in ii. above. Most of this increase is attributable to an increase in the weight of the material price index (MPI) and a decrease in the weight of the fuel price index (FPI). The effect of a decrease in the FPI on the VRCPI was lessened by a reduction in the weight assigned to the FPI, whereas the effect of an increase in the MPI on the VRCPI was amplified by an increase in the weight of the MPI.

[44] The table below provides a summary of the changes for the 2016-2017 VRCPI.

EVOLUTION OF THE VRCPI

[45] The graph below illustrates the impact of the current VRCPI determination in the context of the evolution of the VRCPI since 2001-2002.

Chart details

VRCPI and VRCPI Annual Percentage Change from 2001-2002 to 2016-2017

Crop Year

VRCPI

Annual % change

Average annual rate 1.8% (includes forecasts for 2016-2017)

2001-2002

1.0352

3.5%

1.8%

2002-2003

1.0442

0.9%

1.8%

2003-2004

1.0195

-2.4%

1.8%

2004-2005

1.0108

-0.9%

1.8%

2005-2006

1.0553

4.4%

1.8%

2006-2007

1.1252

6.6%

1.8%

2007-2008

1.0639

-5.4%

1.8%

2008-2009

1.1493

8.0%

1.8%

2009-2010

1.0638

-7.4%

1.8%

2010-2011

1.1384

7.0%

1.8%

2011-2012

1.1777

3.5%

1.8%

2012-2013

1.2919

9.7%

1.8%

2013-2014

1.2691

-1.8%

1.8%

2014-2015

1.3322

5.0%

1.8%

2015-2016

1.2668

-4.9%

1.8%

2016-2017

1.3275

4.8%

1.8%

[46] The VRCPI has tracked up and down since the beginning of the MRE program. Exceptional fluctuations in past years have reflected the volatility of fuel prices, the hopper car adjustment in 2007-2008 and, as outlined in 149-R-2012">Decision No. 149-R-2012, the methodologies to better recognize the cost of capital and the effect on the labour price index of the substantial payments made by CN and CP to their pension funds. The VRCPI has grown at an average annual compounded growth rate of 1.8 percent over the 2000-2001 to 2016-2017 period.

Notes

Note 1

"Other" consists of leased hopper cars, amortization, the cost of capital, the cost of the Canadian Wheat Board cars, the embedded cost for hopper car maintenance, the 2007-2008 actual costs for hopper car maintenance, and the cost changes incurred by each of CN and CP related to the replacement of withdrawn or leased back government-owned hopper cars pursuant to paragraph 151(4)(c) of the CTA.